econguru - Teachers Notes

Microeconomics

Demand
- Definition

o The various quantities of a good or service that the consumer is willing and able to purchase at different price levels

- Law of Demand

o As the price of the good increases, the quantity of the good demanded falls, ceteris paribus.

- Determinants of demand

o The number of buyers
o Tastes
o Income
- § Normal Goods
- § Inferior Goods
o Prices of other goods
- § Substitutes
- § Complements
o Expectation
- § Future income
- § Future price changes

- Exception to the law of demand

o Veblen goods
o Giffen goods
o The role of expectation

Supply
- Definition

o The various quantities of a good or service the firm is willing and able to produce and supply at the market for sale at different prices.

- Law of Supply

o As the price of a good increases, the quantity of the good supplies is also increased, ceteris paribus.

- Vertical Supply Curve

o Fixed quantity of good supply due to:
- § No time to produce more
- § No possibility of ever producing more

- Determinants of Supply

o The number of firms
o Resource prices and costs
o Technology
o Prices of other goods
o Producer(firm) expectations
o Taxes
o Subsidies
o Supply shocks

Market Equilibrium:
- Definition

o The state of balance between the supply and demand forces, where there is no tendency to change.

Government Intervention
- Price Ceiling

o Definition
- § Setting a legal maximum price for a particular good.
o Effects
- § Shortages
- § Smaller quantity supplied and sold
- § Under allocation of resources to the good and failure to achieve allocative efficiency
- § Non-price Rationing
  - Coupons
  - First come first served
  - Favoritism
  - § Information Markets
o Examples
- § Rent
- § Petrol Prices

- Price floor

o Definition
- § Setting a legal minimum price for a particular good
o Effects
- § Surpluses
- § Smaller quantity demanded and purchased
- § Firm inefficiency
- § Over allocation of resources
- § Illegal sales at prices below the floor
o Examples
- § Minimum wage legislation
- § Agricultural goods

- Buffer Stock Schemes

o Setting a minimum and a maximum price for a good

Elasticity
- Price elasticity of demand

o Definition
- § A measure of the responsiveness of the quantity og d good demanded to changes in its price
o Determinants
- § Availability of substitutes
- § Board or narrow definition of a good or service
- § Necessities versus luxuries
- § Length of time
- § Proportion of income spent on good or service
- § Addiction
o Elastic
- § PED > 1
- § Perfectly Elastic,
  - PED = Infinity
o Inelastic
- § PED > 0, < 1
- § Perfectly Inelastic
  - PED = 0
o Unit Elastic
- § PED = 1

- Cross-elasticity of demand

o Definition
- § A measure of the responsiveness of the demand for one good to a change in the price of another good.
o Values
- §
- § If CED = Positive
  - Goods are substitutes
  - § If CED = Negative
    - Goods are compliments
    - § If CED = Zero
      - Goods are unrelated

- Income elasticity of demand

o Definition
- § A measure of responsiveness of demand to changes in income.
o Determinants
- § Necessities or luxuries
- § Income level of consumers
o Values
- § If YED >0
  - Normal good
  - § If YED < 0
    - Inferior good

- Price elasticity of supply

o Definition
- § A measure of the responsiveness of the quantity god a good supplied to change in its price.
o Determinants
- § Length of time
  - Immediate time period
  - Short run
  - Long run
  - § Spare capacity of firms

- Elasticity of demand and supply and incidence of taxes and subsidies

o Taxes
- § PED < PES
  - Consumers more burden
  - § PED > PES
    - Producer more burden
o Subsidies
- § PED < PES
  - Producer more benefit
  - § PED > PES
    - Consumers more benefit

Theory of the firm
- Costs

o Account costs
o Implicit/Opportunity costs
o Economic costs
o Total Costs = Fixed Costs + Variable Costs
o Average Costs
- § U Shape
o Marginal Costs
- § The cost of producing an additional unit of output

- Economies of Scale

o Specialization of labor
o Specialization of management
o Efficiency of capital equipment
o Indivisibilities of capital equipotent
o Indivisibilities of efficient processes
o Spreading of certain cost over larger volume

- Diseconomy of Scale

o Management inefficiency
o Poor worker motivation

- Profit

o Normal profits
o Abnormal profits
o Losses

- Profit Maximization

o MC = MR

- Perfect Competition

o Assumptions
- § Large number of Firms
- § Price taker
- § Identical products
- § No barriers to entry
- § Complete information/ Perfect Knowledge
o Profits
- § Short Run
  - Normal
  - Abnormal
  - Losses
  - § Long Run
    - Normal
o Evaluation
- § Allocative efficiency
- § Productive efficiency
- § Low prices for the consumers
- § Competition leads to the closing down of inefficient producers
- § The market responds to consumer tastes
- § The market responds to changes in technology or resource prices.
o Limitations
- § Unrealistic assumptions
- § Limited possibilities to take advantages of economies of scale
- § Lack of product variety
- § Waste of resources in the process of long run adjustment
- § Limited ability to engage in research and development
- § Market failure

- Monopoly

o Assumptions
- § A single firm
- § No close substitutes
- § Price maker
- § Significant barriers to entry.
o Barriers to Entry
- § Economies of scale
- § Natural monopoly
- § Legal barriers
  - Patent
  - License
  - Copyrights
  - Public franchises
  - Tariffs, quotas and other trade restrictions
o Profit
- § Short Run
  - Normal
  - Abnormal
  - Losses
  - § Long Run
    - Normal
    - Abnormal
    - Losses
o Evaluation
- § Higher prices
- § Lower output
- § Loss of consumer surplus
- § Deadweight loss of welfare
- § Allocatively and productively inefficient
- § Lack of competition
- § Negative impacts to the distribution of income
- § Economies of scale
- § Possible development and technologically innovative (possibly not as well)
- § Possibility of greater efficiency and lower prices due to R&D

- Monopolistic Competition

o Assumptions
- § Large number of firms
- § Relatively low barriers to entry
- § Product differentiation
  - Physical
  - Quality
  - Location
  - Services
  - Product Image (advertisements)
o Profits
- § Short Run
  - Normal
  - Abnormal
  - Losses
  - § Long Run
    - Normal
o Evaluation
- § Allocatively and productively inefficient

- Oligopoly

o Assumptions
- § Small number of large firms
- § High barriers to entry
- § Differentiated or homogenous products
o Shared Characteristics
- § Mutual independence
- § Strategic behavior
- § Conflicting incentives
  - Collusion
    - o Formal collusion: cartels
      - § Obstacles to form and maintain a cartel
        Cost differences between firms
        Firms face different demand curves
        Number of firms
        The possibility of cheating
        The possibility of a price war
        Recessions
        Potential entry into the industry
        Lack of a dominant firm
        Legal barriers.
        o Informal collusions
        Competition
o Non collusive oligopoly
- § Firms that do not collude are forced to take into account of the actions of their rivals in making price decisions
- § Stable price
- § Non-price competition
  - Advertisements
  - Extended warranties
o Evaluation
- § Productively and Allocatively inefficient
- § Higher prices are charged for lower quantity
- § Higher production cost due to lack of competition
- § Less technologically innovative
- § Contribute a more unequal distribution of income
- § Economies of scale can be achieved
- § Product development and technological innovation may be pursued in the long run, improving efficiency, and cost of the product
- § Product development may lead to increased product variety.

- Price Discrimination

o First Degree: Discrimination among individual consumers
- § Assumption
  - Detailed knowledge of each consumer’s demand
  - Ability to prevent resale
  - § Evaluation
    - Increased profits
    - No consumer surplus
    - Increased output
    - No deadweight loss
    - Allocative efficiency
o Second degree: discrimination among quantities
- § Examples
  - Food items
  - Airline tickets
  - § Evaluation
    - Total revenue and profit increase
    - The firm’s output increases
    - There will be an improvement in allocative efficiency
    - Converter parts of consumer surplus and deadweight loss to profit
o Third degree: Discrimination among consumer groups
- § Examples
  - Cinemas
  - Airlines
  - Restaurants
  - Hairdresser
  - § Evaluation
    - Total revenue and profit increases
    - Output may increase or decrease
    - Lower prices for some groups and higher for others
    - Consumer surplus may increase or decrease.
o Overall Evaluation
- § From firm’s perspective
  - Higher revenue
  - Possibility of increased monopoly power
  - No deadweight loss under 1st degree price discrimination (perfect price discrimination)
  - § From the consumer’s perspective
    - Higher/Lower Output
    - Higher/Lower Prices
    - Increase/decrease consumer surplus and better/worse income distribution.
    - Higher prices due to increased monopoly power
    - § From social perspective
      - Allocative efficiency
      - Economies of scale and lower prices
      - Technological innovation.

Market Failure
- Focuses on the free market’s inability to achieve allocative efficiency in a variety of circumstances
- Standard demand curve

o Marginal private benefit

- Standard supply curve

o Marginal private cost

- Externalities

o Definition
- § Externalities occurs when actions of consumer/producers give rise to positive/negative side effects on other people who are not apart of these actions
o Negative production externalities
- § Spillover effects created by the producers
  - Examples
    - o Pollution caused by the firms when producing, causing damage to the environment
    - § Over-allocation of resources, Qe > Qoptimal
    - § MSC<MPC
    - § Correcting negative production externalities
      - Legislation
        o Limit pollution/setting maximum level of pollution
        o Limit output
        o Installation of anti-pollution technology
        § All of these policies shifts MPC to the left
        Taxes
        Tradable permits
        o Permits to pollute issued by the government
o Negative consumption externalities
- § Example
  - Smoking in public areas, cigarettes causes damage for the third party due to passive smoking.
  - § Over-allocation of resources, Qe > Qoptimal
  - § MPB >MSB
  - § Correcting negative consumption externalities
    - Advertising and persuasion
      - o MPB shifts to the left
      - Legislation and regulation
      - Taxes
o Environmental concerns and sustainable development
- § Environmental
  - Pollution towards resources of no ownership
  - Ozone depletion
  - Greenhouse effect
  - Damage to open access resources/common property resources.
  - § Sustainable development
    - Development that meets the needs of the present without compromising the ability of the future generations to meet their needs.
    - Negative externalities on large scales leads to unsustainable development.
o Addressing the overuse of open access resources
- § Taxes
- § Legislation and regulations
- § Advertising and persuasion
- § Tradable permits
- § Extension of property rights
o Positive production externalities
- § Example
  - New medicine, which improves the quality of life for people around the patient.
  - § MSC>MPC, Qe < Qoptimal
  - § Correcting positive production externalities
    - Subsidies
      - o Shifts MPC to the right.
o Positive consumer externalities
- § Example
  - Education as it also benefits the society
  - § MPC>MPB, Qe < Qoptimal
  - § Correcting positive consumer externalities
    - Legislation MPB ->
    - Advertising and persuasion MPB ->
    - Subsidies MPC ->

- Merit goods

o Definition
- § Goods that are held to be desirable for consumers, but are underprovided by the market
o Reasons for under provision
- § Good may have positive externalities
- § Low level of income and poverty
- § Consumer ignorance

- Demerit goods

o Definition
- § Goods that are considered to be undesirable for consumers and are overprovided by the market
o Reasons for overprovision
- § Good may have negative externalities
- § Consumer ignorance or indifference

- Addressing problems of merit and demerit goods

o Direct public provision of merit goods
- § Using tax revenue
o Subsides for merit goods
o Taxes for demerit goods
o Advertising/Persuasion, legislation and regulation for both

- Public goods

o Non-rivalrous
- § Consumption by one person does not reduce consumption by someone else
o Non-excludable
- § Not possible to exclude someone from using the good
o Examples
- § Lighthouse
- § Police force, flood control
o Private goods are rivalrous and excludable
o Problems of public good
- § Free rider problem
  - Good is free and non-excludable, therefore you cannot stop anyone from using it
  - No profit maximization firm will undertake the production
  - § Not provided by the market.
o Non-pure public good
- § Non-rivalrous but excludable
- § Examples
  - Toll-roads, museums
o Correcting market failure for public goods
- § Government directly provide public goods

- Monopoly Power

o Effects
- § Allocative, productive inefficiency
- § Lower output, higher prices
- § Lower/no competition
- § Unequal distribution of income
o Correcting monopoly power
- § Legislation and regulation
- § Public ownership of the monopoly

Macroeconomics
Aggregate Demand
- Shift in aggregate demand

o Change in consumer spending
- § Change in wealth
  - Value of the individual’s asset
  - § Change in expectation about future income
  - § Changes in interest rates
  - § Changes in personal income taxes
  - § Changes in the level of household indebtedness
  - § Changes in the attitude towards spending
    - Sometimes people will tend to save more, during time of war, etc.
o Changes in investment spending
- § Changes in expectation about future sales
- § Changes in technology
- § Changes in interest rates
- § Changes in business taxes
- § Legal/institutional changes
  - Increasing access to credit
  - Property rights
o Changes in government spending
- § Change in political priorities
  - Provision of merit goods, subsidies, etc.
  - May increase/decrease expenditure based on prieorities
  - § Deliberate effort to influence aggregate demand
o Change in export spending minus import spending
- § Change in real national income aboard
- § Change in exchange rate

Aggregate Supply
- Shifts in short run aggregate supply

o Changes in wages
o Changes in non labour resource prices
o Change in business taxes
- § Taxes on firm’s profit
o Changes in subsidies offered to business
o Supply shock
- § War
- § Weather condition

Neoclassical
- Short Run = Nominal wage, Long run = Real Wage, LRAS is vertical.
- Determinants of LRAS

o Exhaustible factors
- § Efficiency
- § Natural rate of unemployment
o Others
- § Quality of factors of production
- § Quantity of factors of production
- § Technology

Keynesian
- Assumed that wages are unable to move into the long run. Hence there is no LRAS.
Demand Side Policy
- Discretionary policy: Policy at the choice and will of the government
- Fiscal Policy

o Government uses tax revenue to finance their expenditure leading to a possible budget surplus/deficit.
o Methods
- § G can be changed as the government alters the level of its expenditure
- § C can be influence if the government charges tax levies on consumers, altering disposable income
- § I can be influence due to change of tax levied on business profits.
o Expansionary fiscal policy
- § Increasing government spending
- § Decreasing personal income taxes
- § Decreasing business taxes
- § A combination of increasing spending and decreasing taxes
o Contractionary fiscal policy
- § Decreasing government spending
- § Increasing personal income taxes
- § Increasing business taxes
- § A combination of decreasing spending and increasing taxes.
o Strength
- § Combating a deep recession
  - When the economy finds itself on the horizontal segment of the AS curve.
  - § Combating rapid escalating inflation
o Weakness
- § Problem of timing
  - When the problem is recognized
  - Deciding the appropriate policy
  - When the policy take effect on the economy
  - § Problems of inadequate information
    - Policies are decided based on possible inaccurate statistics
    - § Political restraints
      - Opportunity cost, e.g. merit, social goods.
      - Taxes are unpopular with the citizens
    - § Crowding out effect
    - § Tax cut may be ineffective in raising aggregate demand during recession
      - Pessimistic attitude about the future increases people’s incentives to save.
    - § Inability to fine tune the economy
      - Hard to lead the economy to a precise standpoint

- Monetary policy

o Carried out by the central bank of each country
o Money supply curve is set by the central bank, shifts to the left to increase interest rates and vice versa.
o Expansionary monetary policy
- § Rightward shift of money supply
- § Decreasing interest rates
- § Increase C, I or both
o Contractionary monetary policy
- § Leftward shift of money supply
- § Interest rates increases
- § Decrease C. I or both
o Strength
- § Relatively quick implementation due to no political process
- § No political restraint
- § No crowing out
- § Relatively better for fine tuning economy
o Weakness
- § Problems of timing
  - When the problem is recognized
  - When the policy take effect on the economy
  - Problems of inadequate information
  - Possible ineffectiveness during recession.

- When the economy is experiencing stagflation (falling GDP and Rising price level)

o Cannot be addressed by monetary or fiscal policy, they only deal with aggregate demand

- Monetary and fiscal policies can be used simultaneously, reinforcing each other’s weakness
- Demand side policies and long term economy growth

o By providing economic stability, businesses can plan further into the future, increasing investment in research and development.
o Directly encourage investment through lower taxes
o Increase in government spending towards infrastructure and education
- § Improving quality of labor and capital goods.

Supply Side Policy
- Supply side polices focuses on aggregate supply and shifting LRAS to the right, achieving a long run economic growth.
- Market Oriented

o Favored by neoclassical economists
o Since real GDP will always move towards LRAS in the long run, the focus should not be stabilization but shifting LRAS to the right
- § This will enable SRAS and AD to shift to the right simultaneously
o May be used to correct stagflation by shifting SRAS back to the right
o Focuses on the introducing legislative, regulatory and institutional changes in the economy, intending to:
- § Increase efficiency in production
- § Decrease the natural rate of unemployment
- § Increase the economy’s production possibilities.
o Methods
- § Reducing the size of the government sector and increasing competition
  - Since a large government sector may be inefficient as it involve bureaucratic procedures, high administrative costs and unproductive workers
  - Governments do not need to maximize profit, hence they’re not concerned with the cost of production
  - Possible advantages
    - o Rise to more competition
    - o Lower costs of production
    - o Greater efficiency
    - o Possible improvement in quality of goods and services
    - Privatization
      - o Breaking up government monopoly into small private firms increasing efficiency due to competition.
      - o Disadvantages
        § The public monopoly may just become a private monopoly:
        High prices, lower output, inefficiency
        Lead to unemployment
        More detrimental if the private sector involves necessity goods such as power water.
        Private financing public good sector projects
        o Where a private firm builds, finance and operate a public service, known as the private financing initiatives. The government then pays private firms for their services
        o Increase competition to be chosen, reducing costs and improving quality
        o Disadvantages
        § Costs may still be higher
        § Reduced project flexibility and government control
        § Inability to adapt to changes
        § May not sufficiently pay attention to safety needs
        Contracting out to the private sector
        o Public services are provided by private firms based on contractual agreements
        o Services includes: information technology, accounting services etc.
        o Disadvantages
        § Inability to respond to changing market condition
        § Loss of internal talent within government sector
        § If project is contracted to another country, loss of employment.
        Deregulation
        o Elimination/Reduction of government regulation of private sector activities
        o Economic regulation
        § Allowing firms to enter monopolistic and oligopolistic competition to improve efficiency
        o Social regulation
        § Protecting consumers against undesirable impacts of private sector activities.
        § Making private firms adhere to public safety.
        o Disadvantages
        § Impacts are no clear
        Sometimes leads to higher prices, lower quality of service, increase in unemployment
        Restricting monopoly power
        These policies are all controversial
        o May heavily depend on the country’s economic social condition
    - § Improving incentives by lowering taxes
      - If the tax cuts work as intended it may lead to
        o Increase in quality of labor, capital
        o Reduction in unemployment
        o Increase in saving, leading to increase in investment
        o Increase in research and technological innovation
        Lowering personal income taxes
        o Lead to higher after tax incomes, and the expectation of increased income is an incentive for people to provide additional work
        § May give rise to inflation if the effect on AD is greater than AS
        Lowering taxes on interest income
        o Increase incentive to save, hence greater investment and increase quantity of capital
        o Disadvantages
        § Inflation, income distribution, government budget deficit
        Lowering business taxes
        o Increase investment and after-tax profit
        o Leading to more capital goods
        o Same disadvantages as the above
        Overall evaluation: A tax cut have both demand and supply side effects, and is believed to have a larger impact on aggregate demand than supply. Hence it may lead to increase consumption rather than saving. Overall, it’s difficult to clearly determine the effects of these policies.
    - § Making the labour market more responsive to supply and demand
      - Also referred as increase labour market flexibility
      - Goals of these policies include
        o Make labour market more competitive
        o Make wages respond to the forces of supply and demand
        o Lower labour cost and increase employment
        Abolishing minimum wage legislation
        o Allow wages to drop to equilibrium and reduce unemployment
        o Firms can hire more labour, increase capital goods production
        o Disadvantages
        § Possible decrease in productivity
        § Increase in job insecurity
        Weakening the power of labour union
        o Increased wage flexibility
        o Disadvantages are same as above
        Reducing unemployment benefits
        o Increase incentives to search for work
        Reducing job security
    - § Liberalizing international trade and capital flows
      - Freeing up trade and capital movement between countries
      - Reduction in trade barriers and exchange controls

- Interventionist supply side policies

o States that the free market cannot achieve an increase in potential output and intervention from government is needed
o Methods
- § Training and education
  - Improve quality of labour
  - § Improved health care services and access to these
    - Increase productivity
    - Increase quality of labour
    - § Research and Development
      - Increase technological advances
      - Creates spillover benefits
    - § Provision of job information
    - § Support for small and medium sized enterprises or firms
      - Creates capital foundation
      - In forms of tax exemptions, grants, low interest loans and business guidance
    - § Support for infant industries
    - § Improvement in infrastructure
o Disadvantages
- § Inefficiency and resource misallocation
- § Opportunity costs
- § Higher taxes and large government sector

The Multiplier Effects
- Definition

o The impact on real GDP of a change in any components of aggregate demand
- § Multiplier = Change in real GDP/ Initial change in expenditure
o Calculating the multiplier
- § Initial increase in AD/Real GDP (Any of the four components, called autonomous spending) produces a further chain of expenditure called induced expenditures.
- § Creates an ongoing cycle as real GDP is essentially income
- § MPC: Marginal Propensity to consume, the fraction of additional income that household spends on consumption of domestic goods and services
- § MPS: Saving, MPT: Tax, MPI: Imports
- § MPC + MPS + MPT + MPI = 1
- § Multiplier = Change in real GDP/ Initial change in expenditure = 1/ (1- MPC) = 1/(MPS+ MPT+ MPI)
- § When MPC increases, multiplier also increases
o Multiplier also applies to decrease in expenditure
o Multiplier effect can only be initiated by a change in spending that occurs in response to a change in non-income factors
o An increase in government spending has a larger impact on aggregate demand than an equivalent decrease in taxes.

The Accelerator Theory
- Investment spending does not depend on the saving, but the change in output (GDP)
- Small changes in GDP can produce a strong impact on investment spending, as GDP changes; investment spending will fluctuate more proportionally.
- When GDP

o Rise
- § Firm engages in heavy investment
o Remains constant
- § Investment drops
o Falls
- § Investment spending falls to zero

The Crowding-out Effect
- Occurs in expansionary fiscal policy
- Increase in expenditure is financed by borrowing (deficit spending)
- Increase in the rate of interest
- Leading to a decrease in investment spending, decreasing AD
- The intended expansionary fiscal policy may therefore ultimately be partially or completely crowded out.
- During an recession

o Keynesian believes that crowding-out’s effect will be reduced
o The neoclassical believes otherwise, they believe crowding out will still occur in a recession.

Unemployment
- Full Employment

o Maximum use of all resources in the economy to produce the maximum quantity of goods and services that the economy is capable of producing.

- Underemployment

o To the number of unemployed people, defined as all people above a particular age who are not working and who are actively looking for a job.

- Measuring employment

- Cost of unemployment

o Economic Costs
- § A loss of real output (real GDP)
- § A loss of income for unemployed workers
- § A loss of tax revenues for the government
- § Costs to the government of unemployment benefits (opportunity cost)
- § Costs to the government of dealing with social problems (crime rate)
- § Unequal distribution of unemployment (racial, gender, age)
- § Unemployed people may have difficulties in finding jobs in the future (current unemployment trend may be extended to the future)
o Non Economical Costs
- § Psychological Stress (mind fucked)
- § Greater Social Problems (crime and violence)

- Natural rate of unemployment

o Structural
- § Occurs as a result of technological change, changing patterns of demand and determine growing and declining industries, and change in the geographical location.
- § Characteristics
  - Long term
  - Most serious type
  - Cost on society, lost output and the lost of income and creating anxiety.
  - Unavoidable in any dynamic, growing economy
  - Can be improved by training workers
  - § Causes
    - Technological change (introduction of ATM)
    - Change in consumer demand pattern (Agricultural workers becoming unemployed as the agricultural sector declines in relative importance and the manufacturing sector grows)
    - Changes in the geographical location of jobs (firms relocation)
    - § Policies
      - Market oriented (supply side policies)
        o Letting wage fall in depressed areas to levels so low that new firms will be attracted to set up their business because of the low of cost of labor.
        o Lowering unemployment benefits in order to make workers accept lower paid jobs
        o Reducing worker’s of security by making it easier and less costly for firms to fire worker (make firms hire new workers.
        o Lowering personal income tax
        Disadvantages
        o Loss of protection
        o Low income workers
        o Increased income inequalities
        o Questionable effectiveness.
        Interventionist
        o Encourage workers with skills that are no longer needed to retrain and obtain skills that are in greater demand
        o Encouraging geographical mobility
        o Encourage new hiring of structurally unemployed workers
        Disadvantages
        o Opportunity cost
o Frictional
- § Occurs when workers are between jobs
- § Characteristics
  - Short term
  - Does not involve a lack of skills that are in demand
  - Less serious
  - Inevitable in any dynamic economy.
  - § Causes
    - Fired like a boss
    - Business got owned
    - Being greedy and looking for a job that provides better pay
    - § Policies
      - Market Oriented
        o Increasing incentives faced by workers to accept work, hence reducing the time in order to find a suitable job.
        Interventionist
        o Providing better information flows between employers and job seekers. Also reduces the time that is need to find a job
o Seasonal
- § Occurs when the demand for labor in certain industries changes on a seasonal basis because of variations in needs
- § Characteristics
  - Unavoidable in any economy
  - § Policies
    - Similar measure as frictional unemployment

- Recessionary-gap unemployment

o Real wage
- § When the actual wage is higher than equilibrium real wage
- § Causes
  - Minimum wage legislation
  - Labor union collective bargaining with employers
  - Maintaining high wage, as they believe this increases efficiency.
  - § Methods of elimination
    - Eliminating minimum wage legislation
    - Reducing the power of labor union
      - o These two actions may only address a part of the downward wage inflexibility. (voluntary increase in wage)
o Cyclical
- § Occurs during the downturns business cycle when the economy is in an recessionary gap.
- § Causes
  - Low aggregate demand, and decline in aggregate demand. Firms therefore lay off workers who are no longer needed.
  - Cyclical unemployment is the total number of unemployed people minus the nature rate of unemployment.
  - § Policies
    - Demand Side Policies, increase aggregate demand
o Conclusion
- § When the economy is in an recessionary gap, there is real wage or cyclical unemployment
- § When the economy is producing at its potential output, there is no real wage or cyclical unemployment, unemployment equals to the natural rate of unemployment: frictional, seasonal and structural.
- § When the economy is in an inflationary gap, unemployment is less than the nature rate of unemployment, as some of those unemployed workers are able to find temporary jobs.
- § Measures to lower the natural rate of unemployment shifts the LRAS Curves to the right.
- § Supply side policies are measures taken against real wage unemployment.
- § Demand side policies are measures taken against cyclical unemployment.

Inflation and Deflation
- Definition

o A continuing increase in the general price level

- Causes of inflation

o Demand-pull inflation
- § Caused by increases in aggregate demand. Rightward shift of the AD curve
- § Prevention Method
  - Demand side polices such as fiscal and monetary. (contractionary)
o Cost-push inflation
- § caused by increases in cost of production, or supply side shocks. Left ward shift of the SRAS Curve.
- § May be caused by the increase in wage, or increase of price in other factors of production.
- § May cause inflation as well as unemployment.
- § No general solutions to the problem as unemployment requires a increase in aggregate demand, and inflation requires a decrease in aggregate demand.
- § Appropriate policies to deal with cost-push inflation must take into consideration of the source of increases in cost of production.
o Excessive growth in the money supply
- § Monetarist economist believe that changes in the money supply have a direct impact on the price level.
- § M x V = P x Q
- § M = the supply of money in the economy
- § V = the velocity of money, also known as the velocity of circulation, defined as the number of times money is spent to buy the goods and services that make up GDP in aparticular time period
- § P = price level
- § Q = physical Volume of output (GDP) produced by an economy
- § Assumptions in this model:
  - Velocity is stable in the short run
  - Q is determined by the quantities and quality of factors or production and technology, independent of the supply of money.
  - § Therefore, any change in M will have an immediate impact on P.
  - § Hence, expansionary monetary policies will not affect unemployment or GDP, but only increase the price level.

- Costs of inflation

o Redistribution effects
- § People who received fixed incomes or wages (worse of due to inflation)
- § People who receive income or wages that increase less rapidly than the rate of inflation
- § Holder of cash
- § Savers
- § Lenders
o People who gay from inflation:
- § Borrowers
- § Payers of fixed incomes or wages
- § Payers of incomes or wages that increase less rapidly than the rate of inflation
o Uncertainty
- § Cannot predict inflation
o Menu cost
- § Costs incurred by firms when they have to print new menus (caused by inflation)
o Money illusion
- § Some people feel better off when their nominal income increases. (retards)
o International competitiveness
- § Decreased due to high prices

- Cost of hyperinflation

o Very high rates of inflation
o Significant increase to the supply of money

- Deflation

o Causes of deflation
o Costs of deflation
- § Redistribution
- § Uncertainty
- § Menu costs
- § Risk of a deflationary spiral
  - Discourage spending, increase unemployment, income and prices
  - § Risk of financial crisis

- Measuring inflation

o Using consumer price index
- § Compares the value of a basket of goods and services in one year
o GDP deflator
o Choose a base year do some division get the inflation rate.
o Problems with CPI
- § Consumer substitution due to change in relative prices
- § Increasing use of sales
- § Introduction of new products
- § Changes in product quality
- § Variations in quantities purchases for different consumer groups or across geographical regions
- § International comparison
- § Comparability over time

The Philips curve, the NRU and NAIRU

Income Distribution
- Deals with how much of the goods and services different individuals or different groups in the population will receive.
- Methods of income distribution

o Transfer Payments: The government transferring payment from the working population to individuals within the vulnerable groups. (Sick, poor, unemployed)
o Subsidized Provision of Merit Goods: The government uses tax revenue in order to provide good in larger quantities than the market would provide. (Subsidizing health and education) Subsidy makes the product available to consumers with lower income.
o Government Intervention in Markets: Including minimum wage legislation, price supports for farmers and provision of subsidies to particular producers.
o Taxation
- § Direct
  - Personal income taxes
    - o Taxes paid by household, including all forms of income, wages, rent, interest, dividends.
    - Corporate income taxes
    - Wealth taxes
      - o Taxes depending on the ownership of assets. Including property and inheritance taxes.
      - Social Insurance
        o Paid by employers and workers for specific expenditures. (pension, health care)
    - § Indirect
      - General expenditure taxes
        o Taxes on goods and services
        Excise taxes
        o Taxes paid on specific goods and services, e.g. cigarettes, petrol
        o Split between consumer and producer
        Customs duties/Tariffs
        o Taxes on imported goods
    - § Proportional, progressive and regressive taxation
      - Proportional taxation
        o As income increases, the fraction of income paid as taxes remains constant; there is a constant tax rate.
        Progressive taxation
        o As income increases, the fraction of income paid as taxes increases; there is an increasing tax rate.
        Regressive taxation
        o As income increases, the fraction of income paid as taxes decreases, there is a decreasing tax rate. Indirect tax is regressive.
        Income exclusive tax
        o A part of the income can be excluded from the tax.
    - § Evaluation of taxes
      - Proportional indirect taxes do not affect the allocation of resources.
      - There’s a trade-off between income equality and efficiency.
      - High taxes may encourage tax evasion, however, many economist suggests that tax evasion still occur regardless of the amount.
      - Taxes may conflict with fiscal policy and income distribution objective.

- Lorenz Curve

o Used to show the degree of income inequality in an economy.
o Broken down into section of 20%.
o The Gini Coefficient
- § Calculated by: Area between diagonal and Lorenz curve divided by entire area under diagonal.
- § Value between 0 – 1, where 0 represents perfect income equality.

- Laffer Curve

o Demonstrates the relationship between tax revenue and tax rate.
o Bell Shaped, where y axis is tax revenue and x axis is tax rate.

International Economics
The benefits of trade
- Specialization

o Increasing domestic production and consumption, increase welfare, greater economic growth, economic development.

- Different factors of endowment
- Economies of scale
- Diversity of choice, Better quality
- Acquire needed resources (Oil)
- Increased competition
- Flows of new Ideas and technological innovation
- Political Reasons - reduce hostility and violence
Absolute and Comparative advantage:
- Absolute advantage

o The ability of one country to produce something using fewer resources than another country.

- Comparative advantage

o A producer or country has a lower relative cost, or opportunity cost, in the production of a good than another producer or country.
o When two countries face an identical opportunity cost, there are no possibilities for those countries to gain from specialization.

- Limitations

o Assumptions
- § Two products
- § Costs do not change due to economies of scale
- § Factors of production are immobile and fixed, they remain in the country
- § Fixed technology
- § Perfect competition/knowledge
- § Full employment of all resources
- § Balanced imports and exports
- § Free trade
o Ignored transportation costs
o May lead to excessive specialization

Free Trade and Protectionism
- Free Trade

o Definition
- § The absence of government intervention in any kind of international trade, where trade take place without any restrictions.

- Protectionism

o Definition
- § Government intervention in international trade through the imposition of trade restriction to prevent the free entry of imports into a country to protect the domestic firms.
o Types of Protectionism
- § Tariff
  - Advantages
    - o Greater local production, increased producer surplus
    - o Domestic employment/economic growth improves
    - o Tariff revenue
    - o Lower imports, lowering possible CAD
    - o Anti-dumping measure
    - Disadvantages
      - o Global misallocation of resources
      - o Increase in prices, decrease in efficiency
      - o Decrease in quantity, loss of consumer surplus, leading to a deadweight loss of welfare
      - o Retaliation
      - o Worsen income distribution, tariff is a regressive tax
    - § Quota (Similar effects as tariff)
      - Advantages
        o Greater local production, increased producer surplus
        o Domestic employment/economic growth improves
        o Quota revenue, for the government or imports depending on the import license.
        o Lower imports, lowering possible CAD
        o Anti-dumping measure
        Disadvantages
        o Global misallocation of resources
        o Increase in prices, decrease in efficiency
        o Decrease in quantity, loss of consumer surplus, leading to a deadweight loss of welfare
        o Retaliation
        o Worsen income distribution, can be seen as a regressive tax
    - § Subsidies
      - Advantages
        o No price increase, no loss of consumer surplus
        o Greater local production, increased producer surplus
        o Lower imports, may improve CAD
        Disadvantages
        o Global misallocation of resources
        o Opportunity cost
        o Retaliation
    - § Voluntary export restraint
      - An agreement between exporting and importing countries in which the exporting country agrees to limit their quantity of export in a specific good below a certain level.
    - § Administrative and technical regulations
      - Administrative regulations
        o Inspection, valuation.
        o How the item is package etc.
        o All kinds of bullshit to reduce quantity of imports
        Health, safety and environmental standards
        o Excessive use of this kind of measure is seen as a disguise
    - § Embargos
o Arguments for protectionism
- § Protecting infant industry
- § Strategic trade policy
- § Efforts of a developing country to diversify
  - Increase the greater variety of goods a country can produce
  - § National defense
  - § Overcome balances of payment deficit
  - § Anti-dumping measure
  - § Protection of domestic employment, growth
  - § Protection for product standards
  - § Raise government revenue
o Arguments against protectionism
- § Raise prices to consumers and producers of the imports that they buy
- § Lead to less choices for the consumers
- § Competition and innovations would diminish.
- § Distorts comparative advantages, leading to inefficient use of world resources.
- § Hinders economic growth
- § Worsen income distribution
- § Downward multiplier effect, trade wars
- § Global misallocation of resources

Economic integration
- Definition

o Economic interdependence between countries, often achieved by agreement between countries to reduce or eliminate trade barriers.

- Trade Bloc

o Definition
- § A group of counties that have agreed to reduce trade barriers to trade for the purpose of encouraging development of free trade.
o Stages of economic integration
- § Preferential trading area: gives preferential access to certain products, reducing but not eliminating tariffs.
- § Free trade areas: An area freely trading among each other
- § Custom unions: Free trade among a few countries, and create a common barrier to any external countries
- § Common Market: Common policies on product regulation, and free movement of goods, services, capital and labor
- § Economic and monetary union: A common market with a common currency
- § Complete economic integration: Individual counties involved would have no control of economic policy, full monetary union, completely harmonization of fiscal policy.
o Advantages
- § Increased competition
- § Economies of scale
- § Use of new technologies
- § Lower prices for consumers
- § Increased investment into research etc.
- § Better use of factors of protection, efficiency increases
- § Political advantages, less war between countries.
o Disadvantages
- § Trading bloc may be a second best solution
  - Inferiority towards the complete elimination of all trade barriers
  - § Create obstacles to achievement of free trade on a global scale
  - § Unequal distribution of gains
  - § The gains from a trading bloc may be limited if a major trade link are with countries the bloc

- Obstacles to economic integration

o Economic sovereignty (Economical decision made by a central body)
o Political Sovereignty (Domestic government loses power)

- Trade Creation

o Occurs when the entry of a country into a custom union, leads to the production of a good or service transferring from a high cost producer to a low cost producer
o Increase in world welfare
o Involves the removal of tariffs

- Trade diversion

o Occurs when the entry of a country into a customs union leads to the production of a good or service transferring from a high cost producer.
o World loss of welfare
o Loss of tariff

World Trade Organization
- Definition

o An international organization that set the rules for the global trading and resolves disputes between its member countries.

- Aims of WTO

o Administer WTO trade agreements
o To be a forum for trade negotiations
o To handle trade disputes among member countries
o To monitor national trade polices
o To provide technical assistance and training for developing countries
o To cooperate with another internal organization

- Advantages

o The system promotes peace in the world
o Disputes handled in a constructive forum
o Small countries have an equal say as larger countries
o Freer trade cuts the cost of living for majority of consumer
o Trade raises income and stimulates economic growth
o Encourages a good government

- Disadvantages

o import decisions are made in information negotiations between small groups of wealthier nations
o Developing nation cannot afford to participate in all negotiations
o A long list of services that should be privatized, low paid work will suffer
o Only lead rich people and nations to a better life
o Unfairly biased towards rich nations as they are allowed to maintain high imports, subsides their agricultural products, banning developing counties from incorporating technology.

Balances of Payments
- Balance of payments account

o a record of the value of all the transactions between the residents of one country with the residents of all other countries in the world over a given period of time.

- The current account

o Measure of flow of funds from trade in goods and services plus other income flows.
- § Balance of trade in goods
- § Balance of trade in services
- § Net investment incomes (interest and dividends)
- § Net transfer of money (donations, foreign aid)

- The capital account

o Measure of buying selling of assets between countries. These assets may include land, real estate, companies, bank deposits, stocks and share, treasury bills, government bonds, foreign currency.
- § Direct investment: productive investment, investment in plant, equipment, machinery or factories(investment in capital)
- § Portfolio investment: investment in shares and bonds
- § Other financial flows: speculation
- § Flows to and from reserves: reserves of foreign currency, to balance the balances of payments

- Current account deficit

o Foreign exchange reserves may be used to increase the capital account and so to regain the balance in balances of payments. (Impossible to fund long-term)
o High level of buying asset for ownership financing the current account deficit.
o Financed by high level of lending from aboard, high interest rate has to be paid.

- Current account surplus

o Allows a country to have a deficit on its capital account
o Leads to an appreciation of the currency, due to the amount of exports.

- Effects of persistent current account deficit financed by loans

o Loss of foreign exchange reserve
o Cost of paying interest on loan
o Fewer imports of needed capital goods
o Possibility of lower economic growth
o Lower living standard
o Possible need for higher interest rates to attract foreign financial investment, leading to recession
o Risk of default on loan (unable to repay loans)

- Effects of persistent current account deficit financed by sale of assets

o Lower standard of living in the long run
o Higher interest rates to attract financial investment, leading to recession.
o Loss of confidence

- Methods of correcting a persistent current account deficit

1. Expenditure-switching policies: where the government attempt to switch the expenditure of domestic consumers away from imports towards domestically produced goods and services.

- Government policies to depreciate or devalue the value of the currency
- Protectionist measure. (may lead to retaliation, and conflict with the goals of WTO)

2. Expenditure-reducing policies: where the government attempts to reduce overall expenditure in the economy, may lead to domestic unemployment.

- Deflationary fiscal policies: increasing indirect tax
- Deflationary monetary policies: increase the rate of interest rate.
- Protectionism

3. Exchange control’
4. Using supply side policies to lower costs of production for firms.

- Effect of current account surplus

o Low domestic consumption
o Insufficient domestic investment
o Risk related to foreign investment

Exchange Rates
- Definition

o the value of one currency expressed in terms of another currency

- Causes of changes in exchange rates

o Interest rate changes and financial capital flows
o Relative rates of inflation
o Changes in income
o Changes in taste
o Speculation
o Use of foreign reserves.

- Fixed exchange rate

o Definition
- § Value of the currency is fixed to the value of another currency, a selection of currencies, or to the value of a commodity (gold). Uses the term revaluation and devaluation
o Advantages:
- § Reduce uncertainty for all economic agents in the country. (Business may plan ahead)
- § Ensures sensible government policies on inflation
- § Reduce speculation, (may not always be the case in reality)
o Disadvantages:
- § High levels of foreign reserves to manipulate supply and demand
- § Raising interest rate may have a deflationary effect on the economy, increasing unemployment.
- § Finding the right fixed exchange rate is difficult. (may affect export industry)
- § May create international disagreement
- § Unable to respond to shocks

- Floating Exchange rate

o Definition
- § An exchange rate where the value of a currency is allowed to be determined solely by the demand and supply.
o Advantages:
- § Interest may be employed
- § Floating exchange rate should adjust itself over time
- § Not necessary to keep a high amount of foreign currencies
- § Protection from external shocks
o Disadvantages:
- § Increase uncertainty on international markets
- § Affected by more factors than demand and supply, such as government intervention, speculation.
- § May worsen existing high inflation.

- Managed Exchange rate

o Definition
- § The central bank sets an upper and lower exchange rate value and then allows the currency to float freely.

- Factors which may affect the demand of a currency

o Buying exports
o Foreign direct investment or portfolio investments into the domestic country
o Save money in domestic financial institutions
o Speculations

- Factors which may affect the supply of a currency

o Buying imports
o Foreign direct investment or portfolio investment to foreign countries
o Save money in foreign financial
o Speculation

- High exchange rate

o Advantages
- § Downward pressure on inflation: (low import prices, hence no imported inflation)
- § More imports are brought, higher standard of life in the short run.
- § A high value of currency forces the domestic producers to improve their efficiency
o Disadvantages:
- § Damage to export industries
- § Damage to domestic industry

- Low exchange rate

o Advantages:
- § Greater employment in export industries
- § Greater employment in domestic industries
o Disadvantage:
- § Inflation. (More expensive raw material, higher consumption due to economic growth)

- Reasons to intervene in the foreign exchange market:

o Lower the exchange rate, increase employment
o Raise the exchange rate, fight inflation
o Maintain a fixed exchange rate
o Avoid large fluctuation in a floating exchange rate
o Achieve relative exchange rate stability in order to improve business confidence
o Improve current account deficit.

- Methods of intervention:

o Using their reserves of foreign currencies to buy, or sell, foreign curries:
o By changing interest rate

- Single currency and monetary union

o Advantages:
- § Reduces the level of transaction cost
- § No longer have to worry about exchange rate fluctuation
- § Easier to make price comparison
- § Greater foreign direct investment due to the reduced transaction cost and uncertainty.
o Disadvantages:
- § A central body controls the interest rate of the whole area.
- § Not possible for one country to depreciate to correct balances of payment
- § Transition from national currencies to a single currency

Purchasing Power Parity
- Doesn’t work in practice:
- Exchange rates changes are partly due to interest rates, intervention and speculation.
- Goods are traded internationally (assumption)
- Barriers
- Goods not comparable.
The Marshal Lerner condition
- a rule that tells us how successful a depreciation or devaluation of a currency’s exchange rate will be as a means to improve a current account deficit in the balance of payment.
- PED exports + PED imports > 1
- Determinant of elasticity of demand is the time period under consideration; the demand becomes more elastic over a longer period of time.
- If the marshal Lerner condition is not satisfied in the short run, a J-curve will be produced, showing that the current account would worsen before improving. This is because the firms cannot react that quickly towards the depreciation, and the factors of production cannot be changed in the short run, therefore in the long run.
Terms of Trade
- Definition

o the rate at which one country’s good exchange against another. Expressed as an index, price changes as a percentage change of the base year.-

- When terms of trade go up, favorable, more imports with same export. May improve standard of living. Vice Versa.
- Significant for developing country, since they are reliant on exports
- Changes in short run:

o Exchange rate, depreciation etc.
o Fluctuation of prices of primary commodity caused by natural disasters etc.
o Usually Supply side

- Changes in long run:

o Increase supply (technology etc.)
o fall in demand
- § Development of synthetic substitutes
- § Low income elasticity of demand for primary commodity
- § Agricultural protection (subsidies)
- § Miniaturization, Smaller products, less use of raw material
- § Price inelastic demand for exports of primary commodities.